Taking AIM @ China where structural growth is now deep value

China facing investments, which represent 30% of the portfolio, continue to come under pressure this month. Those of you who attended our recent presentations are aware we believe this China facing volatility may persist for a little longer.

Firstly, it must be made clear that there has been a complete purge in all China-facing assets globally and all emerging market stocks globally. The rush to the US Dollar, which is now very over-bought (RSI of 71), has pulled the rug from beneath commodity currencies, commodities, commodity equities, Chinese equities, Chinese tech stocks listed in New York. In this indiscriminate purge there is clearly opportunity. Structural Asian Growth stocks have become deep value stocks within a period of three months.

We have seen indiscriminate panic selling. Nothing has been immune. I think in this classic capitulation in all things China facing there is a tremendous contrarian money making opportunity for anyone with more than a one week view. The outright capitulation is presenting a smorgasbord of opportunity in anything inversely correlated to the US Dollar. The fund currently has around 25% cash so we do have capital to deploy at the right prices in the right stocks.

I absolutely expect a recovery in Q4 of China facing assets and I am continuing to take advantage of this capitulation to buy the highest quality China facing structural growth companies. It’s a genuine clearance sale and we must not run away from a clearance sale.

Buying into the peak of gloom requires conviction. Mr Market is now paying you to take the risk on China facing assets and we would argue the margin of safety is now high. It’s time to be a little braver as the world throws the baby out with the bathwater.

While the fund’s recent performance has been poor, and for that I humbly apologise, when I look at our portfolio and the prices today I can see upside in everything we own over the next few years as these now deep value stock become growth stocks again.

I thought it would be useful to also publish the thoughts of China experts CLSA. This is a good summary and I agree with their thoughts.

China Easing – Q4 looks critical

If I roll back to March, when the Chinese government was in full deleveraging mode, and I think about a number of meetings that I had in Beijing and Shanghai over that period, the local focus was not on the implications of deleveraging and whether tighter system liquidity could create an economic scare.

The team was sounding the warning bells though, explaining that the focus on deleveraging was far more apparent than what they had expected, and unless we saw an escalation in tensions as a result of the emerging trade war, and as a result the need for China to ease in order to maintain stability, then the second half was looking challenging.

Well, I think we can safely say that the trade war escalated to levels that most did not think possible, and we are now seeing the government respond with incremental easing measures, which is in line with our expectations. Yet, no one cares, as the recent measures have not had time to take effect.

The situation today reminds me a lot of what I experienced in March, that is the actions were real, but not yet effective, and as such the market was not that concerned. Well the easing actions of today are real, as is the market weakness as a result of macro uncertainty. The question is how long does it take for the current actions to take effect, and in turn the market react?

If you look at liquidity measures such as Shibor, which has fallen 150bps (~35%) in the last 6 weeks, then you’d argue the actions are already in full swing. Property sales and new starts activity are painting a similar picture. But market sentiment does not care, with Shanghai off ~24% from Jan highs.

I continue to think we are building towards a situation whereby current easing measures showing up in the economic data coincides with a distracted USA due to the mid-term elections. A Q4 rally is further supported by China coming back from golden week on October 8, and ramping up activity prior to the environmental reform measures kicking in from early November. Remembering that the supply side curbs are far more onerous from a YoY perspective.

Below are a few more reasons as to why I think we should keep a close eye on current activity, and why a 4Q rally still seems very possible;

Money supply is expanding

CNY-loan growth accelerated in July to 13.2% YoY, the fastest since January (see chart) indicating the relaxation of policy stance of the PBoC in the past few months. Broad M2 money supply growth rose to 8.5% YoY in July from 8% in June.

Bond issuance to ramp up into October

China’s Ministry of Finance on Tuesday ordered local governments to speed up the issuance and use of bonds for designated purposes. The move aims to make better use of the special bonds to stabilize investment, expand domestic demand, according to a document on the ministry website. “By the end of September, new special bonds issued in the first nine months should account for no less than 80 percent of 1.35 trillion yuan (about 197 billion U.S. dollars), this year’s quota, as a matter of principle, while the remainder should be issued mainly in October.”

FX reserves are supportive of currency stability

China forex reserves at end-July were USD3,117.95bn. This is USD5.82bn higher than at end-June (USD3,112.13bn, which was +USD1.51bn from May). This is a very positive result. It indicates that the PBoC has not had to draw down forex reserves to restrain the CNY’s decline from early June.

China property data better in July

Property activity data was actually better in July with NBS data showing the growth in new starts at levels not seen since early 2016. This is helping to explain why the steel complex remains supported and mill margins wide.

Power consumption growth continues

If the Chinese economy was cooling, then it makes little sense that power consumption would continue to grow. Growth did slow in July to +5.7% YoY, but the ytd growth rate is still at +7.8%, and with activity set to increase into year end, then you would expect the momentum to be sustained.

Get the USD right and you’ll make your 4Q

In my mind all of this feeds back to the USD. Based on what we’re saying above, then the expectation is for USD weakness as China easing, combines with currency stability measures, along with a weaker US tape.

As Chris Wood (CLSA market strategist) has been writing, the base case remains that last quarter marked the peak of US cyclical growth momentum post US tax reform. There are now again record short positions on the 10-year Treasury, while speculative positioning on the US dollar is now very much on the “long” side. This is supportive for GREED & fear’s base case, namely that the dollar rally is over.”

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